Financial Markets (2011)

ECON 252 (2011) - Lecture 18 - Monetary Policy

Chapter 1. The Origins of Central Banking: The Bank of England [00:00:00]

Professor Robert Shiller: Today’s lecture is on central banks. We already had a lecture, a few lectures ago, about banks, so what are central banks? Well, today they’re very special government banks that are responsible for the currency, the money. And so, every country in the world has a paper money that has the name of their central bank on it. But I wanted to take the–as you know, I like to understand origins of things–and I wanted to take it back to the beginnings of central banking, so we’ll understand better what the institution is.

I wanted to bring up first the theme of this course, which is that financial innovation or invention is an important process that is not unlike engineering invention. When somebody gets an idea, and it’s proven to work, it gets copied all over the world. That’s the way the human species is. We all have the same kind of cars, we all have the same kind of airplanes. Why? Not because we’re copycats, but because someone has figured out something that works, and of course, everyone copies it. And I think the same thing is true with central banks.

So, I wanted to get to the history of central banks and to go back first to the first central bank. Then, I’ll bring it all the way up to the modern times, where the recent financial crisis–the actions during the crisis, the actions of the world’s central banks was extremely important in preventing what might have been another Great Depression. So, these institutions have become of fundamental importance.

Remember the story I told you in our banking lecture, about how banks got started in the U.K. They’d already been seen earlier in other places, but the really modern banking institution is traced to the goldsmith bankers, OK? So, people used to–there were goldsmiths who made gold jewelry, and people found that, since they had a safe or they had a way of protecting things, they would leave their gold on deposit at the goldsmith banker. And the goldsmith banker would give you a little piece of paper, indicating that you could, any time, come back to the goldsmith and claim this amount of gold. And then, the pieces of paper started circulating as paper money, and that’s how it all started–unregulated, nothing to do with the government. It was just private businesses.

And that system, paper money backed by gold, lasted until the 1970s. Amazing. Well, it wasn’t always gold. It was bimetallic. There would be gold and silver, and things–or all silver–it’s a long story, but we were effectively on the gold standard until just a few decades ago.

But there were problems right from the beginning. And the problem was, that sometimes the goldsmith bankers wouldn’t make good on their pledge to redeem in gold. You’d come with your piece of paper, and they’d say, I’ve gotten too many requests. I don’t have any gold anymore. So, that was the problem.

So, I wanted to start with the Bank of England, which was founded in 1694. And it was just a bank, but it had a special charter from the parliament, from the British government, that gave it a monopoly on joint stock banking, to start with. It would be the only bank in the United Kingdom that was allowed to issue shares and sell shares to a large number of people. There were other banks, but they were partnerships and had only a limited number of partners, so they didn’t get as big. So, the Bank of England became the dominant bank in the United Kingdom.

It started a practice–and this is very important, historically–it realized it had a lot of power, because it was the gorilla bank and there were a lot of little banks. And they realized soon that they could put any bank they wanted out of business, whenever they felt like it. How? Well, because Bank of England was so big, they got a lot of notes issued by these other banks, so anytime they wanted to, they could just present them all for payment, and no bank could withstand that. They didn’t have enough gold on hand. So, they could drive any bank to bankruptcy.

But the Bank of England began to assume its role as essentially a government bank, without being officially government, by using a ”let’s live and let live” policy under one condition: if you are another bank in the U.K., you have to keep a deposit with us, OK? And the Bank of England would tell you how much. If you didn’t do that, you could be destroyed. But that created a stability to the system, because the Bank of England had money to bail them out whenever–you know, they had a deposit with the Bank of England. The Bank of England required that. And so, whenever a bank got in trouble, they could always take their money out of the Bank of England. So, the Bank of England than would help these banks in return for their keeping a deposit, sometimes even lend more money to them. So, that created a stable banking system over the centuries.

So, that was the model for all of the central banks of the world. They’re all copies of the Bank of England. The Bank of England, by the way, was not an independent–it became a government bank. I don’t know the whole history, but it wasn’t really independent of the government until 1997, when the United Kingdom made it formally independent. But nonetheless, it was a model for central banking, and it was observed over much of the world.

Chapter 2. The Suffolk System and the National Banking Era in the U.S. [00:06:27]

Notably, in the United States there was a bank called the Suffolk Bank. This is much later. It was founded in 1819 in Boston, and it was a private bank. And on its own, it just decided to do the same thing that the Bank of England did. It required that all of the New England banks kept a deposit with it. And it did the same thing, and it stabilized New England from bank runs. The Suffolk System lasted until 1860.

So, you can see how central banks are inventions of people. They weren’t government inventions at all. This Suffolk Bank just did this. It became a big and influential bank.

The United States in the first half of the 19th century had repeated banking crises, and there were repeated problems with the currency. It used to be that, if you went to a store and you wanted to buy something, they’d say, let’s see your money. You’d take out all of your money, you’d lay it down, and they’d look at it, and they’d say, well, this is Boston money, this is New Haven money, this is Hartford money. And they would pull out a book called the Bank Note Reporter, and they’d say, well, our money dealers are now doing a 20% discount on Hartford money, so I’ll give you $0.80 on the dollar for the Hartford money. Boston money, we’re down 30% on that. What a messy system.

I shouldn’t mention Boston, because Boston had a good record because of the Suffolk Bank. It was worse in other states, further you got from Boston. So, the Suffolk Bank became held up as a model of a banking system.

But the U.S. also had two banks, one called The Bank of the United States, which was founded in–I’m forgetting the year, it’s not in my notes. Anyone tell me? When was the Bank of the United States founded? 1789, I think. [Correction: 1791] And we had a Second Bank of the United States, but they weren’t really functioning like the Bank of England. They were maybe somewhat like them, but the Banks of the United States were not really central banks, and they were not renewed. They disappeared in 1836.

But the big movement in the United States. Because the United States didn’t want the government involved in private business, they were reluctant to set up a central bank for a long time. In 1863, the U.S. passed the National Banking Act. Actually, there was a revision of it in 1864, and they tried to get some of the advantages of these central banks without actually founding one. So, what they did then is, they said, there’s a new kind of bank called a national bank, and the national bank would have a name like the First National Bank of New Haven. Every city created a bank in 1863, which was called the ”first national bank of something.”

And the government required that they keep on deposit with the Treasury capital to back their currency. So, they were called National Bank Notes that were issued by the banks–printed by the government–but they all looked the same, except they had a different name of the different bank on them. And they had capital requirements, so the banks had to put deposits with the Treasury backing their currency.

That was a success. The United States never again had a problem with its paper money. There was never a problem of discounts anymore. All the national banks would honor each other’s notes at par, and so that’s when the United States had a paper money for the first time.

But it didn’t create a system of stable currency. There were still banking crises, but they had a different form. It wasn’t a failure of the bank notes. We fixed the bank note problem in 1863, but the problem was, there were still runs on banks, and there were still credit expansions and contractions, that led eventually to people in the United States thinking, we’ve got to eventually copy the Bank of England and do the same thing here.

There was a terrible banking crisis in 1893, for example, when everybody thought the banks were going to fail. Somehow they didn’t worry about the currency. The National Bank Notes were thought to be perfectly safe, but they thought the banks weren’t safe, and so there was a crisis, and it led to the depression of the 1890s. Then, there was another one in 1907 that was really bad.

Chapter 3. The Founding of the Federal Reserve System [00:12:08]

And so, people wanted to fix somehow the system, and so, that led to our current system, which has been around almost 100 years. And I call it a copy of the Bank of England, but it might not be described that way by everyone. It’s called the Federal Reserve System, all right? And that was created by an act of Congress in 1913, and it opened its doors in 1914.

But the U.S., again, we always feel that we’re different. We have to make it look different. We can’t just copy the Bank of England. We’ve got to do something different. So they said, why don’t we create 12 banks, that sounds more American, and have them all over the country. And so, we didn’t create a central bank, we have a banking system with 12 Federal Reserve Banks. But of course, they decided to have a headquarters in Washington, DC, called the Federal Reserve Board, or the Board of Governors of the Federal Reserve System. It’s an agency in Washington that oversees the 12 regional banks.

Do you know what region–the country is divided up. What region are we in? It’s Boston. This is the Boston region. So, most of the money in your pocket is Boston money. It only says so now on the $1 bills, I think, but you can look and see where your money came from, which of the 12 banks your currency–but the Federal Reserve System, as founded in 1913, required, just like the Bank of England, that banks have deposits. Either currency in their vaults or deposits with their Federal Reserve Bank to back up their currency. And once again, if they got into trouble, they could draw on their deposits with the Federal Reserve. Or even beyond that, the Federal Reserve could come to their rescue. They’ve been good banks, they’ve kept their deposits–just like under the Suffolk System–they’ve kept their deposits with the Federal Reserve. The Federal Reserve will then help them a little bit more. And so, it became known as the lender of last resort.

And the system also operated something called the ”discount window.” Why do they call it a window? You people never go into a bank anymore, right? Or do you go into banks? Remember, they used to have a teller, and the teller would be sitting at a table, and there was a little something. He’s talking to you through a window. I guess, they wanted to keep you separate from the money. So, there was a window, where a teller would talk to you.

The discount window was a special window at the Federal Reserve Bank for banks to come. This is the metaphor, anyway. I don’t know if they ever had such a window. And so, the bank that was in trouble could go to the discount window, and has to bring something, though. They have to bring some securities as collateral. And so, the teller behind the discount window would discount the collateral brought by the bank, and lend money. It’s called a discount window, because you couldn’t just borrow money, you had to bring some asset as collateral for the loan.

So, in 1913, when the Federal Reserve was founded, President Wilson–who’s the president who signed the bill–was almost ecstatic. I have a quote from that. I don’t remember exactly, but something like, we have put banking crises behind us forever, and this will lead to a system of prosperity and–I can’t think of all the nice words he used. People thought that now that we have adopted the British system, it ought to be smooth just like in Britain. There shouldn’t be a problem anymore.

And so, we still live with that system today. I think Wilson was right. It was a big step forward. Again, it was a copying of other people’s successes. Nobody knows exactly, how the banking system works. There’s a theory of money in banking, but it has worked in practice.

So, central bankers start to become very important in modern society, because they are really the keepers of the gate of sensible lending. There is a tendency for banking systems to over-lend. They create booms, and create a false prosperity for a while, and then it crashes, and we have a banking panic and a recession or a depression.

That means, then, that the banking system has to be the source of stability and good sense. We tend to recruit as central bankers people, who are moral and stable in their lives. One of our Federal Reserve chairs, William McChesney Martin, summed it up very nicely: the job of the central banker is to take away the punch bowl as soon as the party gets going, OK? It’s like a parent, right? You can have one drink, but we’re going to stop. So, that’s what the central bank controls the system through reserve requirements. That is, by telling the banks, who are members of the system, how much they have to hold in reserves, which are deposits at the central bank or currency. If they hold currency in their vaults, if it’s right there, then they’re OK.

This term, reserve requirement, actually goes back to before the Federal Reserve. Because we had state–in the United States–we had state banking regulators that were already imposing reserve requirements. I haven’t tracked down exactly, when it began, but I think, probably around 1900 in the United States, during the Progressive Era.

There are also capital requirements. And I’ll come back to making a distinction between the two. Capital requirements and reserve requirements, both of those terms began to flourish around 1900, even before the Federal Reserve, with state banking regulators, who were requiring both capital and reserves in the United States. I don’t know the history of every other country. But after the Federal Reserve was set up in 1913, it began to take over both of these functions of setting reserve requirements and setting capital requirements.

Let me go a little forward in history. The system appeared great. Now, every country of the world, not just the U.S. and U.K., virtually every country of the world had a central bank. Even communist countries, I think, had central banks. But the system broke down in 1933. Well actually, before ‘33. After 1929, banks started to fail. And the Federal Reserve could have bailed out the banks–in the United States they started to fail, not the United Kingdom. There was a banking crisis after 1929, and it reached its peak in 1933.

So just before President Roosevelt took office, the banks were in total disarray. And the first thing Roosevelt did as president was to shut down the entire banking system of the United States. It was called the banking holiday. Because everyone was running to the bank, it was a catastrophic bank run. Everyone was failing at once. And it was quite a scary situation, because nobody could get their money. The banks were all closed, all of them. And people started to run out of money.

I remember that–was it the Harvard Crimson?–did a poll of its students asking them, how much money do you have in your pocket? And it got down to, like, $0.10 and $0.05. They just spent all their money. What do you do? I mean, how can you get lunch? Well, I assume they had a cafeteria. Somehow, you could still do it. You couldn’t go anywhere and spend any money, if you didn’t have it, because it was all tied up. So, people started changing IOUs, and it was just a mess.

So, the Federal Reserve didn’t stop that crisis, but the Roosevelt administration did other things to prevent crises like this, notably set up the Federal Deposit Insurance Corporation. Now this was a–deposit insurance had preceded the FDIC in 1933, but it had never been a success. It had been tried in a number of places. The U.S., I think, set the example for deposit insurance. And that began to augment central banking. The U.S. had not had another banking crisis since 1933 until 2007, just recently. Well, I should say, there was the Savings and Loan Crisis [in the late 1980s], but not a big banking crisis. And that is testimony to, I think, the importance of deposit insurance.

But the Federal Reserve began to see its role as not so much preventing banking crisis–that was always in the background–but as stabilizing the economy. And so, the Fed began to think of itself as preventing the recurrence of recessions. So, when the economy was over-heating, the inflation was building up, the Fed would raise interest rates, and the higher interest rates would cool down the economy. And when the economy got too soft, when the unemployment rate went up, the Fed would cut interest rates, and that would encourage borrowing, encourage spending, and boost the economy.

Actually, that function of the Fed goes back even before 1933. There’s an economist, Charles Amos Dice, who wrote in the 1920s, that the Federal Reserve is like the regulator on a steam engine. Do you know anything about steam engines? They have this thing that whirls around with two little weights, and if the steam engine gets too fast, the weights spin out by centrifugal force, and it cuts off the steam, so that it doesn’t overheat, the engine doesn’t get going too fast. And so Dice said, the Federal Reserve is an invention, it’s the regulator for the whole economy. And I think he was right, although it’s not as accurate as a regulator on a steam engine, but it works out somewhat well.

Chapter 4. The Move to Make Central Banks Independent [00:25:46]

I wanted to mention that every country now has a central bank, but I just wanted to mention the European Central Bank, because it’s quite new. It’s quite new, and it’s maybe the biggest central bank now in the sense that it–well, I shouldn’t say that. It might be the biggest central bank by some standard. There was a treaty signed at Maastricht in 1992, which led to the creation of the European Union from the European Communities, and it also created a plan for a new currency called the euro, which is a European currency. And the euro did not actually start until 1999, and the currency, actual currency, was not issued until 2002. So, that is a relatively recent invention.

The European Central Bank, or ECB, was founded in 1998–that’s before the euro currency started. They created a list of countries that wanted to participate in the euro zone. Not all European Union countries decided to participate in the euro, notably the United Kingdom had a referendum and voted against it. And to this day, they are not members of the euro. Also [addition: as of April 2011] Sweden, Lithuania, Latvia, Estonia, Poland, Czech Republic, Hungary, Romania, Bulgaria, and Malta are not in the euro zone. [addition: All these countries are members of the European Union (EU).] [correction: Malta officially adopted the euro in 2008, and Estonia in 2011] Some of these countries, that are not officially in the euro zone, use the euro unofficially. It’s not their currency, but there’s no law against your coming in and spending euros, so the euro seems more distributed than that.

So anyway, that’s the most recent central bank, but it’s the same general structure as–every European country has it’s own central bank, like the Banca d’Italia or the Deutsche Bundesbank. But their original purpose is kind of gone, because they no longer maintain a currency. There are no more Deutsche Marks or Italian Lire. They’re all using the euro. So, the real central bank is the European Central Bank in Frankfurt, led by Jean-Claude Trichet right now [addition: as of April 2011].

Bank of Japan, by the way, became independent in 1997. Bank of Japan, another very important central bank. There’s been a movement in the last few decades to make central banks independent. This was something that our own Federal Reserve had from the beginning. It was designed to be separate from the government. The reason was, they thought that a government might want to inflate the currency. Political pressures might at certain times cause them to try to influence the central bank. And so, the Federal Reserve was set up, so that the members of the Board of Governors had 14-year terms. They couldn’t be kicked out, except for impeachment offenses, and so the government couldn’t control the central bank.

The independent central bank has been very important. What tends to happen is, you bring people in, who’ve had long careers in banking, who have a reputation for integrity. And you tell them, that you are the custodian of the currency. You bring in people, who believe in the importance of a stable currency, and then you give them a 14-year term. And they’re there. It’s like the Supreme Court, almost. You can’t kick them out.

Some people think, that’s why the U.S. has had such a stable price level, because of our independent central bank. So many countries have fallen into inflation that has undermined the currency, but the U.S. hasn’t. I think, that’s why there has been a move to copy the independent central bank.

Chapter 5. U.S. Monetary Policy: Federal Funds Rate and Reserve Requirements [00:30:49]

I wanted to talk now about specifics of what the central bank does. Notably, the Federal Reserve System has a committee called the Federal Open Market Committee, FOMC, Federal Open Market Committee, that meets around once a month. And they issue a statement every time they meet, and as it is now–actually, FOMC doesn’t go back to 1913–but I’m talking about the Federal Reserve as it is now.

This committee decides on a range for an interest rate called the Federal Funds Rate. And the federal funds rate is an overnight interest rate that is charged on loans between banks and some other financial institutions. You generally would not have access to the federal funds rate. Now, you probably don’t need it, because you don’t need an overnight loan, anyway. Most of us would borrow money for more than one night, but banks, for various reasons, do this lending and borrowing every day, at least under normal circumstances.

So, we have an overnight interest rate, OK? There’s also a longer federal funds, but we’re emphasizing the overnight rate. And it’s unsecured. This is just an unsecured–there’s no collateral–it’s an unsecured loan between banks. So, the interest rate reflects some risk. Negligible risk, usually, because banks trust each other, at least overnight, right? They know pretty much, they’re going to get paid back. And the current federal funds rate in the United States is 0.13%, as of last Friday [addition: April 1, 2011]. That’s 13 basis points, so it’s virtually zero.

This is a policy decision of the Federal Open Market Committee. They have decided that the range for the federal funds rate will be between zero and 25 basis points, so as of last Friday [addition: April 1, 2011], it was exactly in the middle of their range. The FOMC uses its decisions to set the federal funds rate as a way of stabilizing the economy. This is the regulator that Dice talked about.

Right now, they’ve set it virtually at zero, because the economy is so weak. The unemployment rate last week was 8.8% [addition: as of April 1, 2011], extremely high. And so, the Federal Reserve is not worried about inflation now, it’s worried about high unemployment. And it’s pushed it about as close to zero as it can get it. It can’t go below zero, because you can’t have negative interest rates–no one would lend at a negative interest rate. So, that’s where we are.

Now, I wanted to just tell you about an interesting development that came in just, well, just in 2008. I mentioned that banks hold reserve accounts at the Federal Reserve. Traditionally, those accounts were not interest-paying. Banks had to either hold money or an account at the Federal Reserve for their reserves, and neither of them pay interest, right? If you hold money, you don’t get any interest. If you actually have currency in your vault, you don’t get interest. And until recently, banks didn’t get interest on their deposits at the Federal Reserve, but that all changed in 2008 with the Emergency Economic Stabilization Act, that President George Bush signed. EESA, as it’s called. And EESA allowed the Federal Reserve to pay interest on the reserves, held in accounts at the Federal Reserve, OK?

So, the Fed has a policy now of paying interest on reserve balances. Do you see what I’m saying? I don’t know what the Suffolk Bank did, or the Bank of England did, but I know what the Fed is doing now. If a member bank puts money in deposit with the Federal Reserve, they will get an interest rate. And you can find out what the interest rate is by going to the Federal Reserve website, and right now [addition: as of April 1, 2011] it is 0.25%. So, that’s an important policy change, because now it encourages the holding of reserves.

Some people look at this, and ask this question: Here’s the federal funds rate–why isn’t it the same as the interest on reserves? Interesting question. Why would any bank invest in the federal funds market, if they can get a higher interest rate by just holding a reserve at the Federal Reserve? There’s been a lot of discussion of why that is now. It’s a new phenomenon, because the interest on reserves goes back only less than three years. I think the simplest answer to the question is, that member banks of the Federal Reserve System have stopped lending on federal funds market, basically. They just leave it in reserves, because that’s a higher interest rate.

So, who is lending at this? It turns out that there are some people, notably the government-sponsored enterprises like Fannie and Freddie, that are not eligible for interest on reserves. So, they have taken over the federal funds market.

The reason the Fed added interest on reserves is to create another tool of monetary policy. There’s a lot of concern that, after this crisis is over, there’ll be a sudden surge of inflation. Let me come back to that. Basically, what the Fed has a new tool is, if that happens, to raise the interest on reserves, and that will help contract the economy instantly, very rapidly.

The way the Fed controls the federal funds rate, and has been doing for years, is by buying and selling Treasury bills on the open market, by affecting the supply and demand for short-term credit. And that indirectly–they don’t actually deal in the federal funds market, they deal in the Treasury bill market, but since those markets are interlinked, they indirectly target the federal funds rate.

So, that’s the old way of trading in the federal funds–not in the federal funds market–trading in the short-term Treasury market through the New York Fed. But now, they have a new tool. So, we’re entering a whole new regime of monetary policy.

So, I wanted to talk to about reserve requirements a little bit more and what those are. So, the Federal Reserve has the authority to set the amount of reserves that a bank holds. I wanted to make clear the distinction between reserve requirements and capital requirements. The Federal Reserve has what’s called Regulation D, which specifies how much banks have to hold as a function of their liabilities. And as of right now [addition: April 2011], the reserve requirements are 10% of transaction accounts. That means, that a bank has to total up all of the transaction accounts, and that consists of checking accounts, NOW accounts, and ATS accounts.

Their transactions accounts are accounts like checks that–people have a deposit in the bank, that they’ll use for spending, and those are instantly withdrawable. In contrast, there’s something called ”time deposits.” Those are savings accounts, and the bank does not have to give you the money immediately. In other words, if you go to your checking account [addition: checking account institution], and say, I want my money–it’s a transaction account–they have to give it to you instantly. That’s the rule. But if you go to your saving account, they can stall. You might not have noticed it, but it’s in the fine print somewhere. This is a time deposit. So, the Fed is not worried about time deposits.

Here, we’re talking about reserve requirements. Reserve requirements are still based on the old theory that we’re trying to prevent bank run, OK? We don’t want there to be a run on banks, where people panic and try to withdraw their money all at once. So, we want to make sure the banks have enough reserves, and the Fed currently thinks, 10% ought to be enough.

For time deposits, it’s zero. You don’t have to put any money on reserve for time deposit. Why does the Fed think that? Because you’ve got 60, 90 days, or a year to pay the person back, so they can’t run on you. So, we don’t require any reserve requirements against time deposits. But it’s 10% for transaction accounts, which is substantial, because they’re still worried about this. OK. So, this is the situation.

We used to emphasize in lectures about central banking the so-called money multiplier. The money multiplier, well, it’s complicated, but the simplest thing is, it might be one over the reserve requirement. It’s not exactly that, but if the reserve requirement is 10%, then the total amount of deposits, that banks can issue, is going to be 10 times the amount of currency and deposits they have at the Federal Reserve. So, that means the reserve requirements would fix the money supply under the old theory, because the high-powered money is the currency plus deposits at the Federal Reserve–that’s reserves–and if the reserve requirement is 10%, and banks want to just meet that requirement and nothing more, they’re going to have 10 times as much deposits as there are reserves.

I’m over-simplifying the money multiplier, but I’m telling you that, at the moment in history, it’s irrelevant because banks are holding excess reserves. The world has changed. Just a few years ago, before this financial crisis, banks didn’t want to hold excess reserves, and so there were hardly any excess reserves. Why? Because they don’t get any interest on them. And so, banks didn’t hold excess reserves. So, the money multiplier theory would work, because the amount of reserve was just about exactly equal to 10% of transactions. I’m over-simplifying, but something like that was true. But now they’re paying 25 basis points on reserves, so that’s a lot more than you can get investing in the federal funds market, so banks are just perfectly happy to hold excess reserves.

So, the excess reserves now are over–I think it’s $1.2 trillion. [That was the correct value for February 2011.] It’s huge, because of interest on reserves. I don’t have the exact number. But something has fundamentally changed in just the last few years. So, reserve requirements, they must hold for some banks, but for most banks, they don’t even look at reserve requirements anymore. What do I care? I’m so happy the hold reserves, I’ll hold way more than they require. So, reserve requirements are non-binding for most banks now, so it’s a different world.

Chapter 6. Capital Requirements, Basel III and Rating Agencies [00:45:23]

This brings us, then, to capital requirements. So, in the world–history has always changed–the world, as of a few years ago, everyone emphasized reserve requirements, and those were the requirements that had as its motive preventing bank runs. But we’re not going to have a bank run now, when these banks have over a trillion dollars just sitting there. They’re holding so much, that it’s not an issue right now. So, something else has taken the center stage, and that is capital requirements, which we talked about last time [correction: in the lecture about banks].

So, capital requirements are different from reserve requirements. I just defined–reserve requirements were a fraction of the transaction accounts. They were defined by a liability of the bank. A transaction account is like a checking account. It’s money that the bank owes to other people, and we have this requirement, that 10% of that is the reserve requirement.

But capital requirements are different, and they’re more likely to be binding these days. And these were emphasized in Basel III, which we talked about before. Basel III is not yet in force. It’s going to take a long time. Basel III has a phase-in period that is going to take until, I think it’s 2019. [correct] But there’s a lot of talk now about trying to get Basel III phased in.

Remember, we talked about risk-weighted assets? Now, it is, banks have to hold capital as a fraction of their risk-weighted assets. So, right now, the countries of the world, they’ve agreed, the G-20 countries have agreed on Basel III. But each country has to decide on the implementation of Basel III.

The United States, in particular, is having problems with Basel III, because Basel III refers to credit ratings in many places. But Dodd-Frank, the Dodd-Frank Act of 2010 abolishes credit ratings. The government will no longer make any use, in any regulation, of credit ratings. Remember what credit ratings are. Moody’s and Standard & Poor are the two best-known credit rating agencies.

The government, the SEC, starting in 1975 defined what they called NRSROs. That’s Nationally Recognized Statistical Rating Organization, all right? And that included Moody’s, which was founded about 1900 [John Moody & Co. was founded in 1900], and Standard & Poor’s, which was result of the merger of Standard Statistical Association [correction, Standard Statistics Bureau, sometimes called Standard Statistics Company] and Poor’s [H. V. & H. W. Poor & Co., also called Poor’s Financial Service, Poor’s Rating Service] a little bit after 1900 [Correction: actual merger was in 1941].

They’re venerable old institutions that give a risk rating for securities. For example, Moody’s will give its best securities a AAA rating, OK? That means, Moody’s thinks they’ll never default. Yale University is rated AAA by Moody’s, for example. But if they don’t like you quite as much, they’ll down-rate you to AA. Or if they don’t like you even more, you’re only A. And then God forbid, you go down into the Bs.

In fact, Moody, John Moody, in this book, acknowledges that he took the same grading system that he got in college. It’s a little different. You don’t get a AAA grade here, do you? I’ve never given a AAA. But that’s, how Moody saw it, so it survived. It’s like letter grades to securities.

But Moody did that in 1900. If you read his autobiography, people said, you’re crazy. How can you give a grade to a security? It seemed like a wild idea, but he stuck with it, and over the years, people began to believe in them more and more. So, it led to the idea that we fully understand the risk of securities, and so, a complacency set in, and the government started to recognize these NRSROs as if they were proclaimers of God’s truth. And they started all kinds of regulations, said what your capital had to be depending on the rating of various assets you hold.

But the whole thing collapsed in the recent financial crisis, because some AAA securities lost almost everything. So, the rating agencies made a big problem, issue, and so Congress has now said, nobody can make any regulation based on ratings of the NRSROs.

But Basel III people didn’t get the message. They’re not America, they’re international, and they still believe in them. I think it’s a little bit difficult to know how to handle risk. This is the fundamental problem. And it would be nice, if Moody’s and S&P could tell us, but the problem is that they missed this whole crisis. They didn’t see it coming. And why didn’t they? Well, that’s a deep issue, but that’s what people are wrestling with right now.

So, the U.S. has to figure out what to do to reinterpret the Basel III recommendations for the United States without using any reference to Moody’s and S&P. What will probably happen, I think, is, that the banks will have to have their own risk committees, and they will have to come up with their own assessments of risk, and they’ll be responsible for those. But what will really happen is, they’ll just look at the Moody’s and S&P ratings. It’ll be rubber-stamping them. So, I don’t think that–there’s a whole question whether Dodd-Frank will be effective in reducing our requirement.

Chapter 7. Capital Requirements and Reserve Requirements in the Context of a Simple Example [00:52:34]

But I wanted to go over the capital requirements once again, because now they’re increasingly important. And I wanted to go through just a simple example of capital requirements, so that you’ll understand them. And I don’t think, the general public understands them very well at all. This is old accounting, or old finance. These requirements go back 100 years. I’m going to talk in very simple terms about them, over-simplifying. Basel III is a complicated new agreement. It has a lot of ins and outs, but I’m just going to over-simplify it and talk about the Basel III common equity requirements.

I’m going to tell a little story about founding a bank, OK? Now that’s just to understand how capital requirements work. So, imagine that you decided to found a bank, OK? In developed countries of the world today, you can do this. You can set up your own bank. The only problem you have, you have to get a charter, you have to apply for a charter. You have to decide, whether you’re a national bank in the United States or some other kind of bank, but you get a charter and you open your doors. Now you’ve got to start complying with capital requirements.

But let’s say you do that, all right? You find that there’s an empty bank building downtown, all right? You rent the building, you go through the paperwork, and you set up your bank, and you open the doors. And now, we have one of those windows with a teller, and are inviting deposit, OK? So, I’m going to tell a story, which is over-simplified maybe a little bit.

Let’s say, that you open your doors, and someone walks in with $100 and deposits it, all right? So, this is your bank, or I’ll say my bank. OK. Now, I think regulators would require you to come up with some capital first, but it seems to be a nicer story–you start out with deposit. Assume your regulators allowed you to start. So, somebody walks in and deposits, and here’s your assets, and here’s your liabilities, OK? Left side is assets, right side is liability.

So, someone deposits $100 in cash to your bank, all right?? So, you’ve got an asset now of $100, OK? And you have a liability now of $100. If that’s a savings account, you don’t have any reserve requirements. If it’s a transactions account, you have to hold $10. I’ve got it, right? I’ve got $100 sitting in my vault, because the guy just gave me $100, so I’m satisfying both my reserve requirements and–now, am I satisfying my capital requirements? Well, I have to calculate risk-weighted assets, all right? Remember, every kind of asset has its risk. What about cash? Well, cash has a zero risk, so it has a zero risk-weighting. So right now, my risk-weighted asset equals zero, OK?

OK, I’ve got to satisfy all the regulations that are on me. I’m satisfying my reserve requirements, right? I’ve got my reserve, I’ve got $100. This is cash in my safe, and this is a liability. I owe $100 in the form of a, let’s say it’s a transaction account. Whenever this person comes back, I’ve got to pay $100, OK? So, my reserve requirements are satisfied, because I’ve got more than 10% of my transactions account.

My risk-weighted assets are zero. Now, Basel III says that you have to hold 4.5% of your risk-weighted assets as capital. But now, wait a minute. I have a problem, OK? What is my capital here? I don’t have any capital. I’ve just opened my doors, and I’ve got $100 in assets, $100 in liabilities. Everything looks okay reserve requirement, but there’s no capital.

So, what is capital? I have to issue shares to come up with capital, and I’m going to need–Basel III says, 4.5% common equity requirement. And they also have something called a capital conservation buffer, which is another 2.5%. Plus 2.5%, which you don’t absolutely have to hold, but if you don’t hold it, you’re subject to restrictions, so I’m going to add these. This is the capital conservation buffer. I’ve got to hold 7% under Basel III. And I don’t have any capital here, all right?

So, what do I do? I’m not in compliance. So, I’ve got to raise capital. So, what I can do is I can issues shares. I have to sell shares in the business. So, all I need to do is sell seven–OK, what would it be? Let’s say, I issue $20 in shares, OK? And then, that means someone gives me more cash, because someone paid for the shares. So, I’ve now got $120. Well, I add another plus 20, so it’s a total of assets of 120, all held in cash. Now, this is a different kind of liability. This is common equity.

And the regulators make a big distinction between this kind of liability, the transactions account, and this kind of liability, the $20. Why do they make a big distinction? Because this guy can come to the window any time, and you’ve got to give him $100, whenever this person asks. The shareholders have no demand on you at all. They own a share of the company. They can’t come to the window and demand anything. You can just send them away. The only deal you have with shareholders is, that all shareholders will receive an equal dividend, if the board of directors decides to vote dividends–they’re shareholders in the company. But they can’t run the bank. The shareholders can’t show up at the window, so there’s no risk of bank runs for them. And there’s no risk of problems, because if anything goes bad, you just tell the common equity guys, you’re out, you lost.

So now, what are my risk-weighted assets? They’re still zero. I’ve got $120 in cash. Zero–I don’t have any–7% times zero is zero. So now, I’m in great shape. I’ve satisfied both my reserve requirements and I’ve satisfied my Basel III capital requirements.

So, what do we do next? We’ve created a bank, and there’s no interest paid on these checking accounts, and we’re not earning any interest. We’ve got a bank and we’re satisfying the requirements, but nobody’s making any money, so we’ve got to do something to make money.

So what I’m going to do is, I’m going to–let’s say we get our board of directors meeting–a board of directors elected by the common equity shareholder–and we decide, let’s make some corporate loans. So, why don’t we lend out all of this $100, that was cash, and lend it to some business as a corporate loan, and we’ll charge them interest? Now, we’re going to start making money. So, this is no longer cash in safe, this is corporate loans. Loans to corporations to do business, all right?

So, there we are. Our balance sheet balances, everything looks fine. But what are our risk-weighted asset now? Well, you remember, corporate loans get 100% risk-weight, because under Basel–going back to Basel I, they always thought corporate loans are risky assets. So, my risk-weighted assets are now $100, OK? And 7% of $100 is $7. So, hey, I’m doing fine. Now, we’re capitalized enough, we’re in business. We’re satisfying both our reserve requirements–reserve requirements being 10%–and that’s only $12 [correction: $10], we’ve got it in cash–and we’re satisfying our Basel III capital requirements. So, everything is fine. Everything is fine and we’re in business. And we’re not done yet, because our risk-weighted assets–our $7 is the capital requirement, and we’ve got $20 in common equity. OK. So, everything is great. This is fine.

But now, let’s go on. Now, there’s a crisis. Business gets bad. So, the next thing that happens is 20% of my corporate loans default, OK? And so, we then–it becomes clear, we have another board meeting, and someone says, I have bad news. We made $100 in corporate loans, but these guys–$20 is never going to get paid back. The borrower is out of business. So, I suggest, we do a write-off of our corporate loans, and lets reduce them to $80, OK?

So, what happens? Now, assets have to equal liabilities. $100 is our assets now, not $120, right, because we just lost $20. Our liabilities can’t be $120, because they have to equal our assets. What gives? Well, it’s the shareholders that give, so we mark down common equity to zero. And now, assets and liabilities match.

So now, let’s look at our requirements. What about our reserve requirements? Reserve requirements are fine. We’re holding excess reserves. We’ve only have to hold $10, and we’ve got $20 in cash. But we’re no longer satisfying our capital requirements. So, our bank regulator is going to shut us down, unless we do something to raise capital.

So, how do we raise capital? That’s the next step. Well, one thing we could do is, we could sell some of our corporate loans. We could find a buyer for our corporate bonds, and we could sell, say, $20 worth of them, bring this down to 60, and this would go up to 40, all right? Our risk-weighted assets would now–let me see. No, that wouldn’t do it. Sorry, that wouldn’t do it, would it? We’d still have–I’m sorry, I misspoke. We still don’t have any common equity.

In this case, if we don’t have any common equity, we can’t get out of this by selling our loans. We could have, if it didn’t reduce it to zero. If the common equity went down to $10, then I could sell some of my corporate loans to get out of this mess, right? But I made it zero, so the only way out that I can do, is to issue more shares.

So, I’ve got to go to my friends again and say, well, we started this bank, but we goofed up. We made bad loans, and so we’ve exhausted our common actually. I’ve got to raise more capital now. And so, what you could do is, get more friends to come in. Now, they might not want to do it, because the previous friends got wiped out. They lost everything, right? But you’re coming in as new shareholders on top of the old, and you could then go back to where you were before by just issuing more shares.

Chapter 8. Capital Requirements to Stabilize the Financial System in Crisis Times [01:05:30]

So, this is the system. I think I’ve pretty much summarized it. It’s simple. Now, the issue is, however, that, what motivated Basel III was that–this system of requiring banks to hold capital is supposed to stabilize the system. If they’ve got enough common equity, the bank won’t go bankrupt, even if they lose some of their corporate loans. It would be a big disaster to drive them to insolvency. But the problem is that the system they set up has banks responding to a crisis by selling corporate loans or issuing new shares. The problem is, both of those are hard to do in a crisis.

In a crisis, when everything is falling apart, you go out saying, I want to issue new shares in my bank that just lost everything, the investors are going to say, you have got to be kidding. I’m not going to invest in you right now. So, you can’t raise new equity. OK, what about selling loans? Well, the problem is, in a big national or international crisis, every bank on the planet is trying to sell its loans at the same time. So, it creates a collapse in the system. And this is what happened in the financial crisis.

This story repeated a million times. Banks were trying to raise capital and they were trying to sell assets either by issuing–they were trying to raise capital either by issuing shares or by selling assets. And everyone doing it at the same time created a crunch, and the whole system would have collapsed, if it weren’t for the central banks. The central banks of the world responded quickly by loans to companies, to banks and other companies. So, the lender of last resort saved the whole system from collapsing. That’s the story of the financial crisis.

The remaining story is, the Basel III people in Switzerland said, let’s analyze how we got into this situation. How did it get so bad? And they thought, you know, it’s kind of a funny system, because we’re requiring banks to raise capital at the worst time, and that can’t be the right system. They looked around and tried to decide what to do better. Most countries of the world were following this kind of system. There were some–some people were impressed by the government of Spain having a better system, but the Spanish banking system collapsed anyway, so it didn’t solve the problem.

So, Basel III came up with a solution, which was to allow the central regulators to add another buffer of 2.5%, if they think, there’s a bubble going on. They would do this before the crisis, and that raises the common equity requirement to 9.5%. So, the idea is, this is going to be a problem–raising capital at a time of difficulty is always going to be a problem. And we can always rely again on our central banks, but maybe we can’t, maybe we shouldn’t. And so the idea is, let’s take bank regulators and make it their obligation to raise capital requirements in advance, when they see a bubble coming.

Now, another thing that happened in the United States is the Dodd-Frank Act of 2010. Because of intense public reaction to all the bailouts, said that the Federal Reserve can no longer use discretion in deciding who to bail out. They can operate a discount window, but it has to be completely fair and even for everyone. They can’t decide, we’re going to bail out Bear Sterns, and we’re going to let Lehman Brothers fail. All they can do is operate a consistent discount window. So, they’ve constrained–the Dodd-Frank Act constrained the central bank in the United States from exercising the kind of judgment that saved us from the crisis. And we’re going to have to rely on some different things, like better capital standards, like Basel III, to fix the situation.

Whether we’re there or not, is going to be a big question. This is a complicated system, and we put a lot of the best minds into trying to figure out how to prevent the kind of instability that we’re seeing in this example, where everyone is short on capital at the same time, everyone is selling loans at the same time, and the whole system collapses. We’ve come up with different solutions, but they have to be implemented yet, and there are problems of implementation. The role of central banks and of regulatory authorities are evolving and changing, and it’ll be a period of many years, before we know where the system is actually going.

All right. I will stop here. Next lecture is on investment banking, and we have a former ECON 252 student, Jon Fougner, who is back after nine years, and he will tell us about his experiences as an investment banker, and also a Facebook executive.

[end of transcript]

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